Institutional Investor 2005-06-30 17:43:03
One of the worst-kept secrets in the Syrian Arab Republic is tucked inside a squat concrete office building on an obscure, pothole-ridden street off Harika Square in Old Damascus, the heart of the oldest city on Earth. Up a few flights of well-worn stairs is the office of Yassar Sahloul & Sons Co., Syria's largest money changer. Female receptionists in pantsuits and head scarves greet visitors, and stewards offer cardamom-scented coffee from silver trays. The din of automatic bill-counters riffling through stacks of bank- notes resounds through the lobby and the wood-paneled corridors while clerks rush about in search of signatures and stamps.

In an economy clogged by decades of foreign exchange controls and state ownership, Sahloul & Sons and its smaller competitors are the main arteries of capital to and from the outside world. They operate on the margins of legality -- technically, Syrian law imposes tight restrictions on who may buy dollars or other foreign currencies, and for what purposes. Still, the money changers are tolerated by the government for one compelling reason: Without them, the economy would implode.

"We have been very important to the Syrian economy in the past," says Zouheir Yassar Sahloul, who along with his six brothers launched the company in the early 1980s. "But much is changing, both here and in Lebanon, and who knows what these changes will bring?"

Most of the counterparties for Sahloul and other dealers lie across the border in Lebanon. For four decades, ever since Damascus nationalized its banking industry, Beirut banks have secured much of Syria's savings and financed its commerce. It is a relationship that has survived decades of war, dictatorship and political conspiracy. Today, however, this financial connection -- and the health of the Syrian and Lebanese economies -- is threatened by the political shock waves that have rattled the two countries since the February bombing that killed former Lebanese prime minister Rafik Hariri.

Many Lebanese believe that Syria and its president, Bashar al-Assad, were behind Hariri's assassination. Hundreds of thousands of people took to the streets to demand an end to Syria's 29-year military occupation of their country, an unprecedented show of popular will that forced Assad to withdraw his troops in April. Protesters attacked migrant Syrian laborers, spat on Syrian tourists and trashed the cars of visiting Syrian businessmen. Four months after Hariri's assassination, many Syrians remain afraid to travel to Beirut. For their part, Syrians retaliated by withdrawing millions of dollars in deposits from Beirut banks, forcing Lebanese authorities to defend their currency by selling more than $1 billion of the country's reserves to buy Lebanese pounds. The financial turmoil and political uncertainty have jolted the country's economy. Most economists now expect Lebanon to show no growth this year, compared with expectations of 5 percent expansion before the killing.

"We always thought of Lebanon as this delicate flower," says Abdel Salam Haykal, the president of the Syrian Young Entrepreneurs Association. "And it suddenly became the mouse that roared."

The Bush administration stopped short of accusing Assad of ordering Hariri's murder but made its suspicions clear by recalling its ambassador from Damascus and signaling its desire for the removal of Assad as part of its campaign to democratize the Middle East. Since March, when French President Jacques Chirac told Bush at a dinner in Brussels that Assad was unlikely to survive Syria's withdrawal from Lebanon, administration officials have been meeting with potential alternatives to the regime, including Syrian political exiles. Operations by U.S. forces along the Syrian border with Iraq have put additional pressure on Damascus.

"It will not be a military intervention," says Murhaf Jouejati, a Syrian specialist and a visiting assistant professor of political science at George Washington University. The administration "thinks there will be a coup d'etat if they impose the hardest tasks as preconditions for better relations, such as cutting ties with Hezbollah. It'll be all stick and no carrot."

With its main financial lifeline to the global economy at risk, the Assad regime faces a dilemma. The government has to accelerate reform if it wants to revitalize a stagnant economy and lessen the country's dependence on Lebanon. But opening the economy would force the 39-year-old leader to relax his tight grip on society and would threaten the entrenched interests of a powerful business clique with close ties to the regime.

Syria's conservative Parliament and hidebound bureaucracy have blunted many of Assad's reform attempts by simply ignoring his legislative initiatives. Two years ago the government passed a law allowing the establishment of private banks for the first time in more than 40 years, ending nearly a decade of pitched battles between the Finance Ministry and Parliament. So far three private lenders have opened their doors in Syria; another three have licenses and are expected to begin operations within the next 12 months (see box). The banks are struggling because regulations limit the interest rates they can charge on loans. The Finance Ministry has yet to provide several key supporting measures for the banks, including an interest-bearing facility at the central bank and a database for credit evaluation.

Mohammad al-Hussein, the reform-minded Finance minister, admits he faces an uphill struggle. Responding to complaints from Syria's new private bankers, he recently drafted a proposal to reduce the country's stamp tax, which includes an onerous levy of 6 to 6.25 percent on the value of loans and promissory notes and a separate charge on private banks' total capitalization. It isn't clear, however, when or if Parliament will act on Hussein's proposal.

"I'm not satisfied with the pace of change," he tells Institutional Investor in an interview in his office, which is appointed with opulent inlaid chairs and a bookcase filled with meticulously labeled files. "We're fighting to attract foreign investment, and this [tax] is the kind of thing that has to be lifted or at least reduced to the lowest level possible."

Other needed, and long-overdue, reforms are not yet on the agenda. Syria's big state-owned companies need to be restructured, but the government has ruled out privatization because of the social and political instability it might cause. The government also has no plans to reduce subsidies, which make up 20 percent of the budget and are eroding the country's financial health. The World Bank estimates Syria will post a budget deficit of 4 percent of GDP this year, compared with a surplus of 3.5 percent two years ago, despite the surge in the price of oil, the country's main export. The government continues to buy domestically grown grain and cotton at double the price on world markets while selling gasoline and heating oil at steep discounts.

"The Syrians are very determined to avoid social disruption," says Joseph Saba, director of The World Bank's Middle East and North Africa division. "But things cannot continue as they are."

Unless Assad makes a bold commitment to reform, the country will continue to struggle economically. "To deal with this conclusively requires a major political decision," says Hussein. "Otherwise there will be no meaningful change."

Assad's plight is emblematic of the ferment in the wider Arab world. The war in Iraq unleashed widespread protests against the U.S., but the country's first free elections in January have inspired a clamor for economic and political reform in the region. Tentative moves toward more-pluralist government in Egypt and Saudi Arabia have raised hopes among Syrians for similar reforms.

The need for economic revitalization in Syria is urgent. The economy sputters along on a mix of black-market dealings and oil exports. Growth slowed to an estimated 3 percent last year from 3.4 percent in 2003, according to Hussein. That rate is insufficient for a country whose population is expanding by 2.45 percent annually, and where some 200,000 people enter the labor market each year. Unemployment is estimated at anywhere between 10 and 20 percent. The crucial oil sector is declining rapidly. It generates 37 percent of government revenues today, down from 51 percent in 2002, despite the strength of global prices. Domestic subsidies and declining production are to blame. Economists estimate that the decline in output will accelerate from 2008 and turn Syria into a net oil importer by 2012.

Meanwhile, the forces of globalization are knocking on Syria's door. Damascus signed free-trade agreements last year with Turkey and the European Union that oblige Syria to slash import duties and nontariff barriers, which currently add 20 percent to the price of imports, according to World Bank estimates. "We need to find new sources of public revenue," says Hussein.

The secular state's failure to foster growth is fueling an increasingly powerful Islamist movement. It is barely two decades since Assad's father, Hafez al-Assad, ruthlessly suppressed a Muslim Brotherhood uprising by sending tanks to raze the town of Hama, killing thousands. The challenge for Bashar is to coopt Islamist elements without getting trapped in their potentially lethal embrace. Fundamentalism is particularly strong in Aleppo, Damascus' rival city to the north. The most senior religious leader there, the government-appointed Grand Mufti Ahmad Hassoun, was widely anticipated to be elevated to mufti of all Syria. The expected promotion has been put on hold, however, while the government searches for a successor with enough experience to manage Aleppo's sectarian tensions.

"We still have extremists amongst the men of religion here," Hassoun says from the diwan, or meeting room, of his home. "And I am in a struggle with them."

Analysts characterize Assad as both a would-be reformer and a dutiful son reluctant to dismantle his father's legacy. Powerful forces block the path to reform. Assad must contend with the still-potent Ba'athist retainers and hangers-on from the former regime who keep Syria manacled to its socialist past. "The old guard is not just three or four guys in senior positions but 10,000 fossilized bureaucrats," says Flynt Leverett, who served as senior director for Middle East affairs at the U.S. National Security Council during President Bush's first term and as a senior Mideast analyst at the Central Intelligence Agency. "That's the real obstacle to change."

Syria's oligarchs, known as the New Old Guard, are another powerful impediment. As in other Arab states, many of the country's business elite have gotten rich alongside, or on the shoulders of, the generation of young leaders who have succeeded their fathers to power. Consider Rami Makhlouf, who over the past several years has accumulated some of Syria's most lucrative franchises, including a cell phone company and the country's only network of duty-free retail stores. Makhlouf is a maternal cousin of the president.

These conservative forces help explain the hesitant leadership shown by Assad since he assumed power in 2000. His youth and his background as a London-educated ophthalmologist led many at home and abroad to view him as potentially more liberal-minded than his father. He did introduce some reforms early on, slashing duties on imported cars, banishing military uniforms from schools, phasing out rent controls and lifting press restrictions. A new weekly newspaper, the Lamplighter, briefly emerged as a symbol of a Damascene spring. By the summer of 2001, however, the regime began clamping down again, arresting activists and closing down the Lamplighter. In the past year restrictions on dissent have loosened again and independent newspapers have proliferated, but Syrian dissidents are understandably wary.

"It could well be that nothing has changed, and that this is all just talk," says lawyer Anwar al-Bounni, a senior member of the Human Rights Association in Syria.

The forced withdrawal from Lebanon has raised the stakes for Assad. Analysts in Damascus and Washington say they are watching such prominent officials as Asif Shawkat, chief of Syrian intelligence and Assad's brother-in-law, for signs of a coup. Assad could strengthen his position, they say, by finding ways of preserving the country's vested interests in Lebanon, which Syria accumulated during its occupation. Analysts say Syria will try to build a new network of proxy officials in Lebanon, probably through the patronage of Syrian intelligence agents with legitimate businesses in the country.

Perpetuating Syrian dominance will be especially difficult, however, now that Lebanon has enjoyed a taste of real autonomy. As Institutional Investor went to press, Lebanon was preparing to hold a three-week-long rolling election beginning in late May. Saad Hariri, the late prime minister's son, and Walid Jumblatt, the nation's wily and charismatic Druze leader, are expected to emerge as key players in the country's first freely elected government in a generation.

It's difficult to overestimate the importance of Lebanon to Assad's regime. Military occupation has enabled Syrian businessmen and politicians to extract rich tribute. Some $20 billion has flowed from Lebanon to Syria in the form of remittances from Syrian workers and the sale of cheap Syrian goods, which have displaced Lebanese products, according to a study published recently by An-Nahar, a Lebanese newspaper. Illicit trade has been equally lucrative. Joe Faddoul, an independent Lebanese economist and consultant, estimates that Syrian interests have earned $1 billion to $2 billion a year in Lebanon by selling heating oil on the black market, siphoning electricity from the state electricity utility and rigging bids on road and port projects.

Lebanese banks have been the first port of call for capital fleeing Syria's tight controls. The Syrian Finance Ministry reports that deposits at Syria's state-owned and private banks total some 600 billion Syrian pounds ($11.4 billion) and estimates that an equal amount is sloshing around the black market. Those domestic funds are probably dwarfed by the amount of Syrian-controlled money held abroad, says Finance Minister Hussein. Unofficial estimates suggest that Syrian interests have some $10 billion deposited in Lebanese banks alone.

Hussein hopes to lure some of that capital back home with a raft of financial reforms. In addition to his proposal to reduce the country's stamp tax, he has drafted plans for a stock exchange and capital markets authority. Although Hussein is confident his proposals will become law by the end of this year and the ministry is working with The World Bank to establish listing requirements, he acknowledges that it could take years before Syria has a diversified set of companies worth offering. "We're laying down new laws so that people will feel safe remitting some of that money," he says. "We want to move toward a more liberal, capitalist economy, but there is still this great debate over what a liberal, capitalist economy is."

Lebanon faces equally daunting challenges. With a population of only 3.8 million, the country boasts a per capita income of $4,000, nearly three times that of Syria. Notwithstanding its relative prosperity, however, the country struggles to service a public debt of 180 percent of GDP, the legacy of a massive postwar rebuilding program that did little to address the economy's core problems -- an overbanked financial sector and a reputation among foreign investors for political risk, red tape and corruption.

The political and economic uncertainty spawned by Hariri's assassination has badly hurt growth prospects. Government officials expect the economy to stagnate this year after growing by 4 percent in 2004, and foreign investment is expected to halve, to just $500 million.
In the weeks following Hariri's death, Beirut spent nearly 13 percent of its $11.6 billion in foreign exchange reserves to defend its pound, Riad Toufic Salame, governor of the Central Bank of Lebanon, tells Institutional Investor. He emphatically denies that any withdrawal requests were refused, and the pound, which fell nearly 4 percent after the killing, has recovered to trade at about 1,512 to the dollar.
"The market took a blow," Salame says. "But we reacted accordingly, and exchange rates are now stable."

THE BACKWARD STATE OF SYRIA'S financial system today is an unfortunate departure from the country's rich commercial history. In the eighth century Damascus boasted The World's most sophisticated banking system, based on the silver dinar, which was minted by the Umayyad Caliphate and circulated from Scandinavia to China. A draft order -- known in Arabic as a sek, from which the English "check" derives -- signed against an account in Syria would be honored in Canton. For the next 12 centuries, Damascus served as the financial hub of the Levant. What is today Lebanon existed only as a strip of cities along the coastal frontier of Greater Syria.

It took the colonial ambitions of the U.K. and France in the 20th century to extinguish Syria's long and prosperous trading tradition. With the breakup of the Ottoman Empire at the end of World War I, Paris and London agreed to divide the Middle East into their own areas of influence. The new, arbitrarily drawn borders and restrictions on travel effectively isolated a diminished Syria from its traditional markets in Turkey, Persia and Palestine as well as from the coastal cities enclosed within the tiny new nation of Lebanon. Both countries were made French protectorates. The rest of the Middle East, including today's Israel and its occupied Palestinian territories, Jordan, Iraq and the oil-rich Persian Gulf states, was carved out for the British. Suddenly, to travel from one colonial fiefdom to another, merchants required exit and entry visas, neither of which was easily obtained.

Syria gained independence in 1946 only to endure a series of coups and countercoups. In 1963, following the collapse of the United Arab Republic, a short-lived attempt at Egyptian-Syrian unity, the pro-Soviet Ba'ath Party seized power in Damascus. The party's Moscow-educated leaders pursued a policy of economic nationalization, and by 1965 the Syrian economy was almost entirely state-run. Former air force pilot and then-Defense minister Hafez al-Assad mounted a successful putsch in 1970 and was declared president of Syria a year later. He put an end to the country's political turmoil and liberalized the economy somewhat, deregulating such sectors as tourism and transportation. But he kept the banks under state control, which, not surprisingly, chased the remnants of the country's financial community across the border into Lebanon. Today many of Lebanon's top commercial bankers are Syrian-born, including members of the Azhari family, who occupy senior positions at BLOM Bank, the country's largest lender.

Nabil Hchaime, assistant general manager of Lebanon's Banque Européenne pour le Moyen-Orient, or Bank BEMO, remembers the day more than 40 years ago when his father closed the Damascus branch of the British Bank of the Middle East (later purchased by HSBC Group) and emigrated across the border. "Lebanon was the only country with free movement, good education and health services," says Hchaime. "And that's where capital escaped to."

Since the nationalization of Syria's banks, the country's cash requirements have been met largely by private financiers, ranging from the mighty Sahloul to entrepreneurs working from single offices. By contrast, the country's state-owned banks have failed to provide the capital the economy needs to grow. Official lenders typically require borrowers to secure loans with collateral, usually in the form of real estate, which only wealthy Syrians can provide. Few credit officers have the expertise or daring to lend against a balance sheet or business plan.

"We have banks without bankers," says M. Ayman Midani, a Damascus-based financial consultant. "Our lenders are overwhelmed by regulations. They cannot take initiative and therefore cannot take risks. As a result, there is little business investment."

The state's heavy hand has been a boon for money changers. "This is a cash culture," says Fouad Assi, president of Assi Co., a diversified company that includes foreign exchange dealing. "That's why people feel so comfortable dealing in the black market."

Samir, a veteran money changer who won't reveal his last name, works on the top floor of his family's shop in Souk Hammadiya, which snakes out from the courtyard of the ancient Umayyad Mosque, the dazzling heart of Old Damascus. With nothing more than a telephone, a fax machine and an address book, Samir can arrange money transfers and foreign exchange within 24 hours. Dollars, euros, British pounds and even Japanese yen, he says, can be summoned from the souk's many private vaults. He keeps the money in vinyl bags and locks it in a safe behind his desk.

"I have confidence in the people I deal with," Samir says, showing off a bundle of Syrian pounds the size of a cinder block. "We never count money around here."

The market is cyclical, he explains. In the spring, local currency traders buy Syrian pounds in anticipation of demand from Gulf tourists who summer in Syria. The pounds are smuggled to Lebanon and dispatched to Gulf money changers. When the season ends the Syrian central bank dispatches a clerk to Sahloul & Sons, which as the largest money changer acts as a virtual clearing house, to restore the exchange rate by purchasing surplus pounds. "He arrives with a large vinyl bag and doesn't leave until it's full," says Samir.

For years Samir and his partner ran a lucrative trade arranging remittances for Syrians with family in the U.S. "That was a $50,000-a-year business, and I would take a 2 percent commission," Samir says proudly. The September 11 terrorist attacks put an end to that business, he says. "After 9/11 no one wants to risk the attention of the FBI."

As Samir speaks, a messenger, known in the souk as a forex mule, arrives with an empty black vinyl bag. He dutifully hands Samir an order for $155,000 worth of Syrian pounds to be smuggled into Lebanon, deposited into a local account and then wired to the Paris branch of Lebanon's Banque SBA. Samir casually inspects the order and enters it into a bulging file as the messenger fills his bag with cash -- without bothering to count it.

This informal financial system has kept the country's cash-based economy afloat for decades, but Syria needs a modern banking system and capital markets that can leverage liquidity and finance growth. That is why Bank BEMO's Hchaime has returned to Syria, where he was recently named general manager of Banque BEMO Saudi Fransi. The new private bank's controlling foreign shareholders -- Lebanese, Saudi and French lenders -- own 49 percent of the bank. The balance is held by private Syrian investors, none holding a stake of more than 5 percent.

"It took us three years to get a full banking license," Hchaime says, "and since then we've been lobbying for more services. Right now we're aiming for a share of the trade finance business, but this is just the beginning."

Is Assad listening? Syrians had better hope so. Their future prosperity depends on bankers like Hchaime fulfilling their ambition.